Derivatives%20Markets

1
Derivatives Markets

• Chapter 9

2
Introduction

• Futures, options, and swaps are complicated
  instruments
• However, they have found their way into the risk
  management options of just about every major
  financial institution
• DerivativesA financial instrument/contract that
  derives its value from some other underlying asset

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Futures Markets

• Market in standardized contracts for future
  delivery of various goods.
• Arose in the mid-1800s in Chicago and
  institutionalized an ancient form of contracting
  called forward contracting.
• 1842, Chicago Board of Trade
• 1871, Fire destroyed all records.

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Futures Contracts vs. Forward Contracts

• Futures Contract
• trade in an organized exchange.
• standardized contract terms.
• contract guaranteed by exchange (clearing
  corporation)
• Forward Contract
• transaction in which two parties agree in advance
  on the terms of a trade to be executed later.
• Non standardized contract terms.
• More flexibility.
• Difficult to find a trading partner.

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An Overview of Financial Futures

• Future Contract is a contractual agreement that
  calls for delivery of a specific underlying
  commodity or security at some future date at a
  currently agreed-upon price
• There are contracts on interest-bearing
  securities (Treasury bonds, notes, etc), on stock
  indices (Standard Poors and Japans Nikkei
  index), and on foreign currencies

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An Overview of Financial Futures

• Trading in these contracts is conducted on the
  various commodity exchanges
• Financial futures were introduced about 30 years
  ago and volume now exceeds the more traditional
  agricultural commodities

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Characteristics of Financial Futures

• Standardized agreement to buy/sell a particular
  asset or commodity at a future date and a current
  agreed-upon price
• Designed to promote liquiditythe ability to buy
  and sell quickly with low transactions costs
• Promotes large trading volume which narrows the
  bid-asked spreads
• Allows many individuals to trade the identical
  commodity

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Characteristics of Financial Futures

• Terms specify the amount and type of asset as
  well as the location and delivery period
• Financial futuresunderlying asset is either a
  specific security or cash value of a group of
  securities
• Stock index futurescontract calls for the
  delivery of the cash value of a particular stock
  index

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Characteristics of Financial Futures

• Precise terms of each contract are established by
  the exchange that sponsors trading in the
  contracts
• Seller of the contract has the obligation to
  deliver the securities at a specified time
• In futures markets, the buyer of the contract is
  called long and the seller is called short

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Price of the Contract

• The price is determined by bidding and offering
  that occurs at the location (pit) of the exchange
  sponsoring the auction
• The auction process insures that all orders are
  exposed to highest bid and lowest offer,
  guaranteeing execution at the best possible price

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Market Structure

• Open outcry
• Traders call out offers to buy or sell.
• Gives appearance of chaos.
• Gives all traders in the pit the opportunity to
  accept the offer.
• Seat on the exchange
• Floor Traders

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Clearing Corporation

• The clearing corporation associated with the
  exchange acts as a middleman in the transaction
• Reduce the credit risk exposure associated with
  future deliveries
• Longs and shorts do not have to worry that the
  other party will not perform their contractual
  obligations
• Requires the short and long to place a deposit
  (Margin) which is a performance bond for both the
  seller and buyer
• Requires that gains and losses be settled each
  day in the mark-to-market operation

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Settlement by Offset

• To insure the obligations are met at the delivery
  date, most trades in futures market choose
  settlement by offset rather than delivery
• Both parties make offsetting sales/purchases to
  cover the contract
• Permits hedgers, speculators, and arbitrageurs to
  make legitimate use of the futures market without
  getting into technical details of making or
  taking delivery of assets

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Using Financial Futures Contracts

• Provides the opportunity to hedge legitimate
  commercial activities
• Allows participants to alter their risk exposure
• Hedgersbuy and sell futures contracts to reduce
  their exposure to the risk of future price
  movement
• Permits dealers to cover both the short and long
  position of a contract
• Reduces risk since future prices move almost in
  lockstep with the price of the underlying asset

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Hedging Vs. Speculating

• Short hedgers offset inventory risk by selling
  futures while long hedgers offset anticipated
  purchases of securities by buying futures
• Speculators
• Purposely take on risk of price movement
• Expect to make a profit on the risky transaction

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Arbitrageurs

• Arbitrageurs
• Determine the relationship between the price in
  the cash market and the price in the futures
  market
• During the delivery period of a futures contract,
  the rights and obligations of the contract force
  the price of the futures contract and the price
  of the underlying security to be identical

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Arbitrageurs

• If the arbitrageur senses the price relationship
  between the futures contract and the underlying
  asset is not correct, take actions in the market
  (buy or sell) to make a profit which forces the
  prices into proper relationship
• The activities of arbitrageurs cause the prices
  to converge on the delivery date or be in proper
  alignment during periods prior to final delivery
  date

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Liquidating a Position

• Settlement dates
• Nearby contract
• Distant contract
• Cash settlement contracts
• Settlement by offset
• Open interest
• number of contracts obligated for delivery.
• Each open transaction has a buyer and a seller,
  but for calculation only one side of the contract
  is counted.

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Futures Data

• Wall Street Journal
• Chicago Board of Trade
• Chicago Mercantile Exchange

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An Overview of Options Contracts

• Options on individual stocks have been traded in
  over-the-counter market since nineteenth century
• Increased visibility in 1972 when the Chicago
  Board Options Exchange (CBOE) standardized terms
  of contracts and introduced futures-type pit
  trading

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Stock Options

• Prior to 1973, over-the-counter market
• fragmented
• high transaction costs
• no liquidity
• CBOE established April 26, 1973 and begin trading
  options on 16 stocks
• creation of central market place
• introduction of a clearing corporation
• standardization
• secondary market
• June 1, 1977, SEC allowed trading in puts

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Options

• Contractual Obligations
• Derive their value from some underlying asset
• A specified number of shares of a particular
  stock
• Stock Index OptionBasket of equities represented
  by some overall stock index such as SP 500
• In options on future contracts, the contractual
  obligations call for delivery of one futures
  contract

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Call Options

• Buyer of a call option (long) has the right (not
  obligation) to buy a given quantity of the
  underlying asset at a predetermined price
  (exercise or strike) at any time prior to the
  expiration date

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Call Options

• Seller of the call option (short) has the
  obligation to deliver the asset at the agreed
  price
• Therefore, rights and obligations of option
  buyers and sellers are not symmetrical
• Buyer of the call option pays a price to the
  seller for the rights acquired (option premium)

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Put Options

• Buyer of a put option has the right (not
  obligation) to sell a given quantity of the
  underlying asset at a predetermined price before
  the expiration date
• Seller of the option (short) has the obligation
  to buy the asset at the agreed price
• The buyer of the put option pays a premium to the
  seller

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Summary

• Option buyers have rights option sellers have
  obligations
• Call buyers have the right to buy the underlying
  asset
• Put buyers have the right to sell the asset
• In both puts and calls the option buyer pays a
  premium to the option seller

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Clearing Corporation

• The exchange sponsoring the options trading
  established rules for trading
• Standardization is designed to generate interest
  by potential traders, thereby contract liquidity
• Clearing Corporation
• Guarantees the performance of contractual
  obligations
• Buyers and sellers do not have to be concerned
  with creditworthiness of their trading partners
• Only matter up for negotiation is option
  premiumprice buyer pays to seller for rights

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Using and Valuing Options

• Investors who buy options (puts or calls) have
  rights, but no obligations
• Therefore, option buyers will do whatever is in
  their best interest on expiration date
• On expiration date, payoff on expiration of a
  long call position is either zero (price below
  exercise price) or stock price minus exercise
  price (intrinsic value) (price above the exercise
  price)

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Using and Valuing Options

• A long put position on expiration date has a
  value of zero if price is above the exercise
  price or a value equal to the exercise price
  minus the stock price if price is below the
  exercise price
• Option PremiumThe asymmetry payoff has the
  characteristic of insurance which is why the
  premium is charged on the transaction

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Option Premiums - Calls

• Option premiums are determined by supply and
  demand
• Call options are worth more (higher premiums) the
  higher the price and the greater the volatility
  of the underlying asset, and the longer the time
  to expiration of the option

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Option Premiums - Puts

• Premiums on put options will be higher the lower
  the price of the underlying asset, greater
  volatility of asset and longer time to expiration
• Options are an expensive way to hedge portfolio
  risks if those risks are substantial

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Options Terminology

• Option price (premium) (V)
• Exercise price (strike price) (E)
• Expiration date (maturity date) - Saturday
  following the 3rd Friday of specified month.
• American vs. European Options
• American option - may be exercised at any time up
  to maturity.
• European option - may be exercised only at the
  date of maturity.
• In-the-money
• Out-of-the money
• At-the-money

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Pricing of Options

• The Pricing of Call Options at Expiration
• If VS lt E, the VC0
• If VS gt E, the VC VS-E
• The prices of options on stocks without cash
  dividends depend upon five factors
• Stock price
• Exercise Price
• Time until Expiration
• Volatility of the Underlying Stock
• Risk-free Interest Rate

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Options Investors Buy Hedges,Then Hunker Down
and Wait

• NEW YORK -- Option trading was defensive but
  noncommittal, mirroring investors' guarded
  ambivalence as they endured updates of the Iraq
  standoff, terrorism alerts and a reminder from
  the Federal Reserve about the precarious state of
  the economy.
• Here is what one investor did John Jacobs, who
  runs the Jacobs Co. mutual fund in Charleston,
  W.V., this week bought 1,500 March 79 puts on the
  DJX, which has one-hundredth the value of the Dow
  Jones Industrial Average. The puts provide
  downside insurance through mid-March,
  particularly if the Dow industrials remain below
  7900. "We're being very defensive to protect the
  stock side, where we have been writing covered
  calls," he said, referring to the fund's approach
  of investing in blue-chip stocks and selling call
  options against the stocks for income.

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• To help offset the cost of buying the puts, Mr.
  Jacobs sold 1,000 DJX February 77 puts Tuesday,
  essentially betting the blue-chip index will hold
  its ground in the immediate term. Mr. Jacobs said
  he believes blue-chip stocks are oversold and
  could get a small lift from Fed Chairman Alan
  Greenspan's somewhat-encouraging comment that
  capital spending should improve once the Iraq
  situation is resolved. Also, he said, any
  terrorist attacks that would roil the markets are
  less likely to occur until after the hajj, the
  climax of the Muslim pilgrimage to Mecca later
  this week.
• Mr. Jacobs plans to buy back the February 77 puts
  later this week, possibly at a cheaper price
  because the short-term puts lose their value
  rapidly as they approach expiration next week.
• The Dow industrials fell 77 points to 7843.11. At
  the Chicago Board Options Exchange, the DJX March
  79 puts gained 20 cents to 3.70. The DJX
  February 77 puts gained 20 cents to 1.40.

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• Caution remains the watchword. "In this market,
  you should be more concerned about protecting
  profits than giving up upside," says Elliot Spar,
  Ryan Beck Co. option strategist.
• One way investors protect profits, Mr. Spar said,
  is with so-called collars, where an investor
  sells a call to define a target price at which he
  is willing to sell stock while using the proceeds
  to buy a put for downside protection. "This puts
  a floor under the stock and caps the upside" at
  the strike price of the call, he said.

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Options Data

• Wall Street Journal
• Chicago Board Options Exchange

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Swaps

• The 1st major swap occurred in August of 1981.
  The World Bank issued 290 million in eurobonds
  and swapped the interest and principal on these
  bonds with IBM for Swiss francs and German marks.

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An Overview of Swaps

• Two broad varietiesInterest rate swaps and
  currency swaps
• Swaps are contractual agreement between two
  parties (counterparties) and customized to meet
  the requirements of both parties

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Counter parties

• Fixed-rate payer
• Party to a swap that makes fixed-rate payments in
  exchange for floating-rate payments.
• Floating-rate payer
• Party to a swap that makes floating-rate payments
  in exchange for fixed-rate payments.

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Obligations of payments every six months for the
duration of the swap
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Interest Rate Swap

• The fixed-rate payer always pays the same amount
  while payments by the floating-rate payer varies
  according to the reference rate
• The dollar amount of the payments is determined
  by multiplying the interest rate by an
  agreed-upon principal (notional principal amount)

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What determines the rates paid by both parties?

• Shape of the yield curveexpected rates in the
  future
• Risk of defaultpossibility that counterparties
  might default on scheduled interest payments
• Financial institutions facilitate swaps
• Act as the Swap Dealer
• Bring the counterparties together
• Impose their own credit between the counterparties

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The Swap Dealer

• Commission compensates the dealer
• For matching parties in the swap.
• For risk of default by the counter parties.
• Dealer can reduce risk by diversifying swaps
  across many unrelated counter parties.
• Offers liquidity - willing to cancel contract in
  exchange for an appropriate payment.

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Valuing a Swap

• Contracts are traded in over-the-counter market
• It is possible for one of the counterparties to
  sell their obligation to another party
• Changing market conditions may cause one party to
  sell obligation
• The third party will purchase the swap if it is
  to their advantage
• Therefore, swaps produce gains or losses which
  will ultimate impact the value of the swap

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A Simple Interest Rate Swap
This Year
Bank One Bank Two
Two-year loans earn 9 fixed Two-year loans earn 8 variable
Deposits cost 5 variable Deposits cost 6 fixed
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Next year rates go up.
Bank One Bank Two
Loans earn 9 fixed Loans earn 12 variable
Deposits cost 9 variable Deposits cost 6 fixed
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Next Year Rates Go Down
Bank One Bank Two
Loans earn 9 fixed Loans earn 5 variable
Deposits cost 2 variable Deposits cost 12 variable
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Next Year Rates Go Up They swap.
Bank One Bank Two
Loans earn 9 fixed Loans earn 12 variable
Deposits cost 6 fixed Deposits cost 9 variable
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Next Year Rates Go Down They swap.
Bank One Bank Two
Loans earn 9 fixed Loans earn 5 variable
Deposits cost 6 fixed Deposits cost 2 variable
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Interest Rate Swap
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Currency Swaps

• Two companies agree to exchange a specific amount
  of one currency for a specific amount of another
  at specific dates in the future.